OREANDA-NEWS. Fitch Ratings has downgraded the Long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating for Apollo Investment Corporation (Apollo) to 'BBB-' from 'BBB'. The Rating Outlook has been maintained at Negative. Today's rating actions have been taken as part of Fitch's periodic peer review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.

BDC INDUSTRY OUTLOOK

Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at an 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of approximately 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS

IDRs AND SENIOR DEBT

The downgrade of Apollo's ratings and the maintenance of the Negative Rating Outlook are driven by the firm's continued outsized exposure to oil & gas investments, which remain pressured by depressed commodity prices, in addition to large exposures to aircraft financing and structured investments, in combination with, what Fitch believes to be, relatively high leverage levels, particularly given the risk profile of the portfolio. Realized and unrealized losses on the portfolio have increased over the last 12 months, as has the proportion of the portfolio on non-accrual status. Fitch believes further portfolio valuation declines are likely, given market volatility and commodity price movements, which will pressure already high leverage levels. Dividend coverage could decline, given contraction in the interest-bearing portfolio, lower origination volume, and the potential for additional investments to be placed on non-accrual, although will likely by cushioned by management fee waivers and offsets and an interest expense benefit.

Despite these challenges, Apollo maintains a solid BDC platform, leveraging its relationship with the parent company of its manager, who has a strong track record in the credit space.

Oil & gas investments accounted for 12.9% of the portfolio at Dec. 31, 2015, according to Fitch's calculations, which is the highest for the rated peer group. In the first six months of fiscal 2016, Apollo recorded realized and unrealized losses on oil & gas investments, including Miller Energy Resources, Inc. (Miller Energy), Osage Exploration & Development, Inc. (Osage), and Spotted Hawk Development, LLC. Further market movements or company-specific challenges could result in incremental valuation hits in coming quarters and eventual credit losses, particularly if oil prices remain at depressed levels.

Fitch recently conducted a stress test on BDC energy exposures and believes Apollo's leverage ratio is one of the most vulnerable in the peer group, given its outsized exposure to energy overall, and oil & gas more specifically. A stress on the overall energy book, based on Sept. 30, 2015 balances, yielded a 12 basis point increase in Apollo's already-high leverage ratio.

Exposure to aviation amounted to 15.2% of the portfolio at Dec. 31, 2015, consisting solely of the firm's investment in Merx Aviation Finance, LLC, which owns a diverse portfolio of used, current generation aircraft. Apollo holds a first lien investment in Merx, with a 12% coupon, in addition to 100% of Merx's common equity. Fitch views the entire investment as a levered equity position, as Apollo is the majority owner. Fitch believes this investment is outsized, which in combination with the cyclical nature of the aviation industry, introduces more valuation volatility than a portfolio of first lien positions that are diversified by obligor and industry.

Structured product investments, consisting largely of middle market CLOs and credit-linked notes, accounted for 10.7% of the portfolio at Dec. 31, 2015, which is above the peer average. While Fitch recognizes that a portion of these investments are driven by strategic partnerships, like with Madison Capital, where Apollo has full view of the collateral in the structures, the firm remains in the junior position of relatively highly levered vehicles, which exposes the firm to more valuation volatility and potential loss.

Further, exposure to preferred and other equity securities represented 13.3% of the portfolio at Dec. 31, 2015, consisting of investments in renewables, shipping, and the ownership interest in Merx, amongst other equity investments. While Fitch believes the broader Apollo platform has experience investing in these industries, these investments are relatively new to the BDC platform, and it will take some time to observe their credit performance, earnings, and contribution to valuation volatility, given their categorization as equity exposures.

Investments on non-accrual accounted for 7.4% of the debt portfolio at cost and 3.3% of the debt portfolio at fair value, at Dec. 31, 2015, which is above the peer average. A second lien investment in Miller Energy and a first lien investment in Magnetation, LLC and Osage account for the vast majority of the non-accrual exposure and are oil & gas and metals & mining investments. Fitch believes Apollo's non-accruals could increase over the near-term, given continued pressure on commodity prices.

Apollo's leverage target is 0.75 times (x) at the upper bound. At Dec. 31, 2015, leverage was 0.8x at par, which is above the peer average. Fitch believes Apollo's leverage is high, particularly given the firm's outsized exposure to aviation, oil & gas, and structured products, combined with limited access to the equity markets and the potential for incremental portfolio depreciation given market volatility and oil price declines. Additionally, the average underlying portfolio company leverage was 5.4x at quarter-end, which is modestly above the peer-average. The recognition of additional unrealized depreciation and/or credit losses would increase leverage, thus pressuring asset coverage ratios.

Since the establishment of the share repurchase program in August 2015 through Feb. 8, 2016, Apollo has repurchased approximately $62.4 million of stock, representing 4.5% of initial shares outstanding. This has yielded $0.07 of per share accretion to NAV. While Fitch appreciates the motivation for the stock buyback, meaningful share repurchases are viewed unfavorably given the firm's current leverage levels. Fitch would view a reduction in debt, via portfolio proceeds, favorably.

Fitch believes Apollo has been successful improving its funding flexibility in recent years, and 61% of its total debt was unsecured as of Dec. 31, 2015. However, this is expected to decline to 46.5%, on a pro forma basis, following the refinancing of $200 million of convertible notes with secured revolver borrowings, which occurred in January 2016. Apollo has another $29 million of secured term notes due in September 2016, which Fitch believes will be refinanced with secured revolver borrowings and/or portfolio proceeds. Borrowing capacity on the corporate revolver will decline from approximately $798.5 million at year-end 2015, given the convertible note maturity mentioned above.

Apollo's core operating performance is under pressure and expected to remain so over the remainder of calendar 2016. Interest income declined in the first nine months of fiscal 2016 with a reduction in the size of the interest-bearing portfolio, an increase in non-accrual levels, and a decline in prepayment fees. This dynamic is likely to continue as energy investments remain under pressure and leverage levels limit growth prospects. Apollo's earnings yields remain in-line with the peer group, but are benefiting from the management and incentive fee waivers that have been in place since April 2012. Further benefits will be realized from lower interest costs, given the refinancing of fixed cost debt on the corporate revolver, and from management fee offsets related to the adviser's sub-advisory agreement with CION Investment Corporation.

Net investment income per share continues to exceed dividends declared, and, in 2016, will benefit from the refinancing of higher-cost debt on the corporate revolver ($0.06 per share annually), but revenues are likely to remain under pressure given current leverage levels and the potential for increased non-accruals, particularly in energy. Additionally, cash earnings coverage of the dividend is likely to decline, as non-cash income, like paid-in-kind interest, is elevated compared to peers and could increase further with portfolio company strain. Furthermore, dividend coverage on a taxable income basis is considered weak, given the amount of realized losses recognized by the firm, aggregating to nearly $1.2 billion since 2005.

RATING SENSITIVITIES

IDRs AND SENIOR DEBT

Apollo's ratings could be downgraded should leverage ratios not decline to a level commensurate with the risk of the portfolio. A weakening liquidity profile, deterioration in asset quality (particularly in non-energy investments), material expansion of sector (eg aircraft leasing, structured product) or industry (eg oil & gas) concentrations, and/or an inability to cover dividends with core earnings could also result in a ratings downgrade.

A revision of the Outlook to Stable will be dependent upon the management of leverage at a more appropriate level, the absence of material losses (realized or unrealized) or credit deterioration, particularly in the oil & gas portfolio, structured products, equity investments, and 2013-2015 portfolio vintages, which have been originated in a more challenging market environment. A reduction in portfolio concentrations, improved operating performance, and an improvement in dividend coverage on a taxable income basis could also yield positive rating momentum.

Headquartered in New York, NY, Apollo is an externally managed BDC, organized on Feb. 2, 2004. As of Dec. 31, 2015, the company had investments in 95 portfolio companies amounting to approximately $3.1 billion.

Fitch has downgraded the following ratings:

Apollo Investment Corporation
--Long-term IDR to 'BBB-' from 'BBB';
--Senior Secured Debt to 'BBB-' from 'BBB'; and
--Senior Unsecured Debt to 'BBB-' from 'BBB'.

The Rating Outlook is Negative.